Engaging in business transactions with family members comes with many potential risks. Sometimes the financial relationship creates a strain on the personal one. In other cases, no such personal stresses occur, but other unpleasant surprises nevertheless await. The taxpayers in the case of DeFrancis v. Commissioner found this out, as they failed to follow certain formalities related to the home loan they received from a family member, and that failure ultimately cost them the right to claim a mortgage interest deduction on their taxes.

In 2001, Christopher DeFrancis and Jennifer Gross purchased a home in Northampton, Mass. They financed the property with two loans, a smaller loan from TD Bank and a larger loan from Gross’s mother. In 2009, the couple paid $19,230 in interest to the mother, and $1,138 to the bank. When they filed their 2009 federal income tax return, they claimed a mortgage interest expense deduction for the full $20,368.

The Internal Revenue Service disallowed $19,230 of the deduction, and tacked on an accuracy penalty of $1,346. The couple brought the matter to the U.S. Tax Court, arguing that the loan to the mother was a qualifying mortgage loan. The court disagreed, explaining that the loan failed to meet the regulatory standard for a secured debt. The federal tax regulations define secured debt as meeting three criteria established in Section 1.163-10T(o)(1), and the couple’s loan from the mother satisfied only the first one. The second criterion stated that to qualify, the loan must give the lender the same rights to the property as a bank mortgage or deed of trust. The third criterion required that the loan be recorded, or otherwise perfected under state law.

The loan from the mother failed each of these criteria for the same reason: no one ever recorded the instrument with the local register of deeds. As a result, the loan extended by the mother would not give her the same rights as a lender whose mortgage was recorded, and was never perfected under Massachusetts law.

The court, however, sided with the taxpayers regarding the applicability of the accuracy penalty. The loan the couple claimed as a qualifying mortgage was neither phony nor fraudulent. The only reason the couple erred in claiming the deduction was because the loan failed to meet the “highly technical” regulatory criteria for secured loans. That the loan was not a qualifying instrument would not have been apparent to the couple, who were not tax experts, the court concluded, striking their liability for the $1,346 penalty.

Navigating a federal income tax return can be unexpectedly complicated, as deductions or credits that may seem self-explanatory may be laced with statutory or regulatory technicalities that may trap the unwary taxpayer. To ensure you are entitled to all the deductions you claim, and have claimed all the deductions to which you are entitled, consult with the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. They have years of experience dealing will all manner of credits, deductions and income tax issues, and have current and in-depth knowledge of the laws and regulations, to ensure your return is fully compliant. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.